Monday, October 23, 2017

Investing in a Rapidly Changing Diamond Industry

Investing in a Rapidly Changing Diamond Industry
By: Michael Molman

            Diamonds are called “a woman’s best friend”. They can be used to show off your incredible wealth, cut granite, or launder money if you’re an African warlord. In any case diamonds are the physical representation of opulence, and the industry is going through a period of change that provides investors with huge opportunities.
            The diamond trade has traditionally been one of the most secretive industries in the world. De Beers, a diamond cartel, had an almost absolute monopoly on the business for over 100 years, during which it regulated the supply of diamonds and kept prices inflated. A few diamond trading houses located mostly in Antwerp, Belgium, were designated “sight holders” by De Beers and could purchase rough diamonds in bulk (rough diamonds are diamonds yet to be cut and polished). These diamond trading houses were the secret link between diamond mines in African countries like Botswana and premium jewelry outlets in New York, London and Hong Kong. Diamond trading was a largely deregulated affair and deals were often done behind closed doors with little or no paper trail. While other industries modernized, and were transformed by improving technology, diamond trading remained entrenched in its roots.
            This all began to change during the early 2000’s when suddenly people began to notice how diamonds were financing brutal regimes and atrocities in Africa. Movies like “Blood Diamond” and “Lord of War” showed how diamonds illegally sourced in war zones in Africa using slave and child labor, were used to finance war and horror. Amid public uproar governments began to increasingly scrutinize the diamond industry. Under increasing public pressure and government regulations De Beers made the decision to only sell diamonds sourced at its own mines (before De Beers would force independent diamond miners to market and sell their diamonds through them, threatening to flood the diamond market with supply if the independent miner refused.). Free of the De Beers diamond monopoly smaller diamond miners began to grab market share and produce their own diamonds and for the first time there was no single player regulating the supply.
             At the same time as the De Beers monopoly was being taken apart diamond traders began to look to new growth markets. A rise in incomes and a new middle class in large emerging countries like China and India created a whole new class of people who could afford to buy diamonds. This convinced diamond traders that the demand for jewelry was about to explode. To be ready for the increased demand, diamond manufacturers (those who cut and polish diamonds), began to buy up rough diamonds in bulk. Banks, hoping to take advantage of the coming diamond boom themselves, were more than happy to extend large amounts of credit to these diamond manufacturers. The increased demand for rough diamonds allowed diamond miners to raise prices for rough stones. From 2009 to the Spring of 2011 rough diamond prices rose 75%. The expectation of strong demand for diamond jewelry in China and India led to over speculation in the diamond market which created a diamond bubble. In the Spring of 2011 the bubble burst. Demand from China, although growing rapidly, was not enough to meet the expectations of the diamond industry. This caused diamond prices to collapse, from their 2011 highs to 2012 diamond prices crashed 20%. Suddenly an over leveraged diamond manufacturing industry was facing significant losses and was forced to curb rough diamond buying. This has led to a long-term recession in the diamond industry.

IDEX Diamond Index showing cut diamond prices from January 2013 to July 2017. Oversupply and changing consumer tastes have pressured prices.

Six years after the bursting of the diamond bubble the industry still faces significant hurdles, chief amongst which is lack of financing. Diamond trading is a capital-intensive business, traders often borrow hundreds of millions to buy stones, and until recently banks were willing to lend this money to them. However, due to a fall in diamond prices traders are having a harder time paying back loans taken out before the crash. This coupled with new regulations by governments have led banks to make the decision to pull out of the diamond business entirely. Banks like KBC Group and Standard Chartered, formerly the largest lenders to diamond traders have decided to pull out of the business. Standard Chartered alone has already taken over $400 million in losses on its diamond loans and still needs to recoup some $1.7 billion in loans to diamond traders. KBC Group meanwhile has taken more drastic measures in trying to recoup its diamond loans. In August, KBC had the offices of diamond distributor Exelco which owed the bank $30 million, raided. This raid forced Exelco, a De Beers “sight holder” and prominent diamond trader which sold to retailers like Signet Jewelers and Jared Galleria, to declare bankruptcy. Other diamond traders are hardly faring better, fellow Antwerp diamond trading house, Arjav Diamonds, has seen revenue decline over a third from two years ago to $542 million and has had debt increase to over $500 million. Some traders have cash reserves so low they have trouble finding people willing to do business with them.
            While diamond traders suffer under the weight of bad loans and lack of financing, diamond retailers like Signet Jewelers and Tiffany face slower diamond sales in Western markets. Changing consumer preferences and falling marriage rates are taking their toll on companies who derive much of their income from selling expensive diamond engagement rings. Meanwhile diamond miners have seen their stocks crushed after a series of issues including mine setbacks, political fights, and low prices. Shares of smaller diamond producers have on average fallen 30% in 2017, meanwhile the overall mining sector is up by double digits. Every part of the diamond supply chain seems to be in complete turmoil and this has led to investors shunning the industry. However, there is light at the end of the tunnel, certain developments are in the works that could revive and transform the industry and that is where the opportunity is.
            Diamonds have many uses, as the hardest substance found on Earth they have many industrial uses and because of their natural beauty they are popular in jewelry. These features mean that no matter what diamonds will always been a source of value, much like gold. However, while gold was mined in large enough quantities to be used as currency, diamonds are rarer so it was never practical to use them as money. This meant that even when gold currency was disbanded, several gold exchanges popped up to allow traders to invest and trade the metal. Now days over 60% of gold is used for investment purposes and only 40% is used for jewelry. There is now a push to make diamonds the next gold, an investable commodity that can be traded on exchanges around the world allowing investors to hedge risk.
            If diamonds become an exchange traded asset like gold, silver or platinum, it would bring greater liquidity, price transparency and stability to an industry which has been in turmoil for years. This is not a new idea, the diamond industry has been trying to set up diamond based investment derivatives for years, the problem always was, unlike gold, there is no one type of diamond. Diamonds come in different colors, clarity and cut, this makes it incredibly difficult to create a standardized investment grade diamond product.  Also, there has never been a spot price for diamonds, prices usually varied from vendor to vendor. These things meant that to invest in diamonds one needed to be an expert. This is beginning to change as some people are trying to create a modern market for investment grade diamonds.

Diamond Futures
            In August of 2017 The Indian Commodity Exchange (ICEX) launched the world’s first diamond based futures contract, to provide Indian diamond exporters with a way to hedge prices. India is one of the largest centers for diamond trading in the world, 14 out of every 15 rough diamonds that comes out of the ground is cut and polished in India. From March 2016 to March 2017, India imported about 153 million rough diamond, worth about $19 billion and exported over $24 billion in cut and polished stones. Indian banks, unlike their western peers, have been eager to lend to diamond traders, partially filling the financial void left by the exit of other western institutions.
            Those facts have encouraged some in India to launch a diamond futures contract to help deliver greater liquidity and price transparency. Contracts will be for 1 carat with expiration in November, December and January. ICEX’s diamond future gives traders their first opportunity to speculate on diamonds, which opens the industry to the public for the first time.

Diamond Bullion
            Futures contracts are not for everyone, they tend to be too risky and complex for average investors. Therefore, in October of 2017, the Singapore Diamond Exchange (SDiX), launched another exchange traded diamond product, diamond bullion. This bullion will be a credit card sized package of investment grade diamonds, that will be exchange traded, allowing investors to trade it globally similarly to how they trade gold or silver bullion. There will be two different types of diamond bullion, silver; which began trading at $100,000, and gold; which will include higher end stones and be worth $200,000 (begins trading in January). The prices of these two types of bullion are determined by supply and demand, like any other exchange traded asset. The diamonds included in each bullion are authenticated by the Institute of Diamond Grading a Research, a unit of De Beers which makes sure that the diamonds are ethically sourced (that they are not blood diamonds) and are indeed investment grade.
Diamond bullion is meant to open the diamond trade to the public like never before by providing investors a standardized way to invest in diamonds. It also creates a real possibility to make diamonds a whole new asset class onto itself, a safe haven that could compete with gold and have a place in everybody’s portfolio.
           
The question is, will investors accept diamonds as a new investment product? After all prices have suffered in recent years and investors might be concerned about investing in a commodity as controversial as diamonds. It is true it will take a while for diamond exchange traded products to catch on and go mainstream, but recently the diamond industry has begun to normalize. To support diamond prices large producers like De Beers (no longer a diamond monopoly but still controlling 35% of the market), and ALROSA, a Russian mining giant (20% of the worlds diamonds are sourced in Russia), cut production of rough diamonds. They also made it more difficult for diamond traders to buy in bulk by requiring them to be more corporate and provide financial information, something unheard of previously. Meanwhile new company’s like Dfin (a London based corporate finance firm) have plans to loan the diamond trading industry as much as $250 million to take advantage of the current lack of competition in diamond financing. These efforts to stabilize prices appear to have worked with rough diamond prices up about 5% in 2017. According to diamond analyst Paul Zimnisky prices could rise another 5-10% this year as the global supply glut begins to subside.

Diamond index created by diamond analyst Paul Zimnisky that attempts to track global rough diamond prices. Rough diamond prices have largely stabilized in 2017.

                  While prices for rough diamonds begin to recover prices for polished gems used in jewelry remain under pressure. Demand for diamond jewelry in markets such as the U.S have been stable at best with diamond retailers like Signet Jewelers showing sales declines. However, large diamond producers known for their expert marketing techniques, are increasing their advertising budgets and changing their marketing strategies to connect to a new generation of consumers. Diamond jewelry sales are expected to increase 4% between 2016 and 2021.
            Despite the slowing sales of diamond jewelry, the real opportunity for the diamond industry is for investment diamonds. At the moment 95% of diamonds are used for consumer consumption, the other 5% are used for industrial purposes (this field is mostly controlled by synthetic diamonds) and investment purposes. With diamond trading becoming more open and with new diamond derivatives popping up around the world, the demand for investment diamonds will increase. Especially when you consider the fact that diamond production is expected to slow dramatically in the coming years, with new diamonds being sourced from deeper and more expensive mines.

Chart shows how diamond supply is expected to fall off after 2030 with demand continuing to grow steadily.

            Diamonds have the potential to become the next big publically traded commodity, the industry has already embraced the concept. Large miners such as De Beers and smaller miners like Petra Diamonds have already voiced their support for publically traded derivatives like India’s diamond futures, and Singapore’s diamond bullion. Diamond exchange traded assets will stabilize the diamond industry by opening it up to the public, providing greater price transparency and liquidity. Investors will potentially have a new safe haven asset something that can rival gold and protect them from inflation, geopolitical risk or stock market crashes. People who start to pay attention to the industry now, while it is hurting and transforming, stand to make a fortune when the transformation is finished and the industry is thriving.

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Disclaimer: This material has been written for informational purposes only, it should not be considered as investment advice. Any investment decision should be made after consulting multiple sources and a financial advisor. 




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